A pension pot of around £100,000 offers a wide choice for your pension income options. Add to that the freedom of choice for annuities (thanks to the 2015 pension reforms) and you’ve got a lot to think about!
Annuity rates aren’t fantastic at the moment – and haven’t been for a while. With economic and political uncertainty facing the UK in the years ahead, it’s hard to commit to a financial plan, too.
Here, we’ll look at your annuity options – and other ways you can draw an income from your pension pot.
- The problem with annuities
- Why temporary annuities could be the solution
- How to get a better rate if you do take out an annuity
- Is there an alternative to annuities?
- Income drawdown
- Flexible drawdown and lump sum
- Uncrystallised flexible drawdown
- What else can you do?
Once you’ve picked your annuity, you can’t undo your decision. So, if you pick what seems like a great rate now – but find a better deal next year, it’s tough luck.
Think of annuities as an insurance product rather than an investment. The rate you’re offered depends a range of factors such as your age, health, and lifestyle choices. The provider has to decide how long you’re likely to live (and, as such, how much money you’ll get through before you die).
So, if you’re taking a pension at the age of 55 and you’re a marathon runner, you’ll get a bad rate. The provider thinks you’ve got a long life expectancy. This increases their risk that they’ll pay out over the odds on your retirement income.
On the other hand, if you’re not taking your pension til you’re 65, you have a lengthy medical history, and you smoke – let’s face it, providers think you’re a good bet. Enhanced annuities offer you a larger income – because providers think you’re not going to live as long.
So, if you’re in fantastic health and buy an annuity – what happens if you then have a serious illness? You’re stuck with the annuity you bought when you were healthy. This is why annuities are a tricky subject to balance.
Lifetime annuities are the most common – but did you know you can take a short-term one, too?
A temporary annuity is set for a period of time up to five years. This is a good way to generate some income from your pension pot without locking yourself into a lifetime annuity rate.
This type of annuity does eat into your pension pot. The rate will be higher than an equivalent lifetime annuity, to reflect the low-risk level and short-term arrangement.
At the end of the annuity, when it matures, you’ll need to consider another annuity or investment option. With less in your pension pot than before, your options could be limited.
However, if you need to generate some retirement income and don’t want to lock into a lifetime annuity (just yet, at least), a temporary or fixed-term annuity could be the solution you need. Speak to your pension provider or an independent financial adviser to find out all the pros and cons of taking a temporary annuity for your personal circumstances.
The number-one rule is to shop around for the best annuity on the market.
You don’t have to buy an annuity from your existing pension provider. It’s your legal right to shop around and get the best rates from any annuity provider on the market.
In the years leading up to your retirement age, your pension provider will get in touch and prompt you to buy an annuity. Never automatically take what’s on offer from your existing pension provider. You could net an extra 20% in retirement income simply by shopping around and picking the best deal.
Consider all of the options including joint-life annuities which continue to pay some or all of the income to your partner if you die. Enhanced annuities offer better rates for smokers and people with medical conditions, which can even cover a relatively mild condition such as high blood pressure. There are also investment-linked annuities which carry some potential for income growth (linked to the performance of a with-profits fund). These are fairly complicated vehicles so never take one out without taking professional advice.
Chris Daems of IFA Principal Financial Solutions says: “Ensure that when looking for the best annuity on the market your providers are aware of your health, smoker status and height and weight. It’s possible that you might see a significant boost in your income if your health isn’t tip top, you are a smoker, or you are overweight.”
Yes: you have a couple of options here.
You can choose:
- Income drawdown
- Flexible drawdown and lump-sum
- Uncrystallised flexible drawdown with lump-sum
- Trivial commutation for small pension pots
Don’t worry if these sound confusing – we’re here to help!
You used to have to buy an annuity by the age of 75 – but these days, you never have to buy one if you want to use income drawdown.
Every year, you can take up to 150% of the Government Actuary’s Department rate – set every three years. Or, you can choose to leave your pension invested and not take an income at all.
You’ll get a regular income at an agreed rate from your pension pot. The rate is capped – that means there’s a limit to how much money you can receive each year. You can choose to take a tax-free lump sum up to 25% of the total pension pot and then receive an income, or start receiving the income without the lump sum.
Income drawdown also means you can monitor annuity rates and wait until they improve for your circumstances. If you die after taking an a standard single-life annuity, the money goes to the insurer’s pocket – not your loved ones. So, waiting until you know what suits your retirement AND inheritance plans could work best for you.
The risks of income drawdown
Annuity rates might not rise over time – so if you’re waiting, you might end up buying at a lower rate anyway.
Leaving your money invested leaves it open to the standard risks of investment. This means your pension pot could reduce quickly over time if bad investments are made.
Keeping money in the fund also means you’ll face management fees and charges – eating into your fund.
Tax implications of income drawdown
If you don’t take your tax-free lump sum, you’ll receive the first 25% of your income payments tax-free. After that, it’s taxed at your marginal rate.
Some joint-plan agreements let your spouse continue to take the income when you die – without paying extra tax. If you nominate someone else, they’ll pay up to 55% ‘death tax’ on the money they receive.
But if you’ve chosen to take the lump sum, this will be rolled into your estate for inheritance purposes. When you die, any remaining monies in your pension pot are paid to your dependants or nominated beneficiaries minus the ‘death tax charge’.
A crystallised flexible drawdown lets you take your money as and when you want it. Instead of a regular income, you can leave the pot invested until you want to take lump sums (or set up regular payments – that’s also an option).
You no longer have to meet the Minimum Income Requirement – where you had to prove you had £20,000 income from other sources – to qualify. Anyone can now choose this option. You withdraw money as you wish, rather than receiving a regular income.
This gives you added flexibility to access your cash whenever you want. It’s ideal if you have other investment plans for your cash, such as buying property, as you can get hold of lump sums when you need them.
Not all of your pension pot will be ‘crystallised’. An amount three times the size of your chosen tax-free lump sum taken will count as crystallised. So, if you took 20% as a lump sum, 60% of your fund is crystallised. The remaining amount is left uncrystallised. This is important for tax purposes.
Tax implications of crystallised flexible drawdown
The same death tax rules apply. However, the uncrystallised portion, if left in your pension pot when you die, will not be subject to the death tax.
Your dependent can withdraw the crystallised cash as an income (at their rate of income tax) – with the death tax charged each time they make withdrawals.
If you choose an ‘uncrystallised fund pension lump sum’ it works like the flexible drawdown. However, instead of the first 25% being tax-free – whether as a lump sum or as a regular income – you’re taxed on 75% of each withdrawal.
Put another way, 25% of every withdrawal you make will be tax-free.
Why would you want to start paying income tax as soon as you draw your pension?
Well, ‘uncrystallised’ rules apply to the money left in your pension pot. This means that, if you die before your pension pot is emptied, and before the age of 75, ALL money left in your pension is paid tax-free. There’s no death tax charge.
If you’re worried about providing for loved ones after you die, this option reduces the tax bill they could face.
Defer your retirement and carry on working
If you continue to work, even on a part-time basis, you take home more of your pay packet. How? Because after state pension age you don’t have to worry about National Insurance – which also leaves you more cash each month to pay into your pension pot before you retire.
If you do decide to buy an annuity later on, you should be offered a better rate because you’re older and have a shorter life expectancy. In addition, as people get older, they’re more likely to suffer from medical issues which could mean you become eligible for an enhanced annuity.
Boost your state pension
For every five weeks that you defer taking your state pension, your future allowance goes up by 1% . This increases the weekly payments you receive when you do choose to take it.
Find other ways to make and save
Think carefully about how much you’re likely to need in retirement. Remember that some costs will be lower (you don’t have to pay National Insurance) while others may be higher (healthcare, utilities).
Take advantage of state provisions and perks for the over-60s, too. Free bus passes, winter fuel payments, and warm home discounts all help reduce your living costs in retirement.
If there’s still an income shortfall consider other ways to boost your income. You could rent out a spare room to a lodger for extra cash (you’re allowed to make up to £7,500 a year tax-free under the Rent a Room Scheme), or even downsize your home to release equity (although don’t forget there will be costs associated with selling up and buying somewhere else). Read our money-making ideas for pensioners here.